Multinationality and Financial Performance

Most of the world’s 500 largest firms have extensive international operations; indeed, these firms average 35% of their sales in other countries. Finance officers and senior executives involved in strategic management usually assume that such firms are operating globally.

Executive Summary

•  Senior executives, especially finance officers, need to be aware that standardized metrics to evaluate international performance are only applicable when firms operate globally. Now that research shows that large firms actually operate regionally, it is necessary to use new regional metrics to measure performance.
•  Regional variables are important new measures that supplement the traditional measures of multinationality; indeed, the regional measure is a superior measure of the financial performance of multinational enterprises (MNEs).
•  There is evidence that MNEs perform in an intraregional manner, on the basis of both sales and assets; there are strong intraregional effects across all industry sectors.
•  Analysis of multinationality and financial performance needs to take into account the new metrics available on regional sales and assets, and the return on foreign assets.

Introduction

Most of the world’s 500 largest firms have extensive international operations; indeed, these firms average 35% of their sales in other countries. Finance officers and senior executives involved in strategic management usually assume that such firms are operating globally. This is a bad mistake, since recent academic research has demonstrated that the vast majority of the foreign sales of these firms are actually made within the firm’s home region of the broad triad of the European Union, North America, and Asia–Pacific. In other words, the world’s largest firms are actually operating regionally rather than globally.

The regional nature of business means that the traditional financial and accounting metrics used to evaluate international performance need to be revised. These measures assume that firms operate globally, such that financial performance can assume standardized operations across the world. (Globalization is usually defined as worldwide economic integration leading to standardization and commonality.) Instead, financial performance needs to be measured within the home region and not globally. Large firms face additional risks in expanding operations beyond their home region. Such additional risks need to be compensated by a better performance on interregional sales in contrast to the less risky intraregional sales. In this article we outline the nature of regional activity and the new regional metrics required to measure the financial performance of large firms.

The Regional Dimension of Multinationality and Performance

Recent empirical research has established that MNEs operate regionally rather than globally. It was shown by Rugman and Verbeke (2004) that only nine of the world’s 500 largest firms operate globally, i.e. in all three regions of the broad triad of North America, Europe, and Asia–Pacific. In contrast, of the 380 firms that provide data for the year 2001 on the geographic scope of their sales, 320 average 80% of such sales in their home region. In Rugman (2005) some 60 cases were examined to establish the robust nature of this regional effect. It was also demonstrated that whenever data on assets were provided by firms these upstream production data also revealed a regional rather than a global effect. The implications are that the MNEs are more likely to source through regional clusters than through a global supply chain. However, robust testing of the asset data remains to be undertaken.

We shall now present data on both sales and assets. These data are presented for the five-year time period 2001–05. The purpose of these data will be to demonstrate that the regional effect is applicable over time and that there appears to be no trend towards globalization. Rather, these data indicate that there is a longitudinal argument that regionalization is now a stable phenomenon.

Table 1 reports data on intraregional sales and assets for the period 2001–05. This is for a set of the world’s largest 500 firms. Among 500 firms, geographic sales and assets data are available for 386 firms during this period. The data are compiled from the annual reports of these publicly traded companies. These annual reports are now available on the internet under each company’s name. This table updates and supplements the data for 2001 reported in Rugman and Verbeke (2004) and in Rugman (2005). In Table 2 data are reported for the ratio of regional to total sales (R/TS) and also for the ratio of regional to total assets (R/TA). In addition the table reports the conventional measure of multinationality in previous empirical research. This is (F/TS), i.e. the ratio of foreign (F) to total (T) sales. The table also reports the ratio of foreign to total assets (F/TA). For more detail, see Rugman (2007).

Table 1. Foreign and intraregional sales and assets of large firms, 2001–05

 The table reports that the average (R/TS) for the world’s largest firms is 75.7%. There is almost no variation over time. Next the table reports that the average (R/TA) is 76.7%. Again, there is very little variation over time. These data suggest that the world’s largest firms are slightly more regional on assets than on sales. Table 2 also reports that the average (F/T) for sales is 35.2%, while the average (F/T) for assets is 32.5%.

 Choosing the Correct Metrics

There is an interesting variation by triad region. In Table 2 the (F/TS) for Europe is 55.5%, and for assets it is 52.1%. This partly reflects the historical lag in statistical data collection whereby the 27 member states of the European Union still record trade, foreign investment, and foreign sales data across country borders. In practice, the European Union is now an integrated internal market with common political institutions, a uniform judicial system, and one with a common currency for most of the member states. Thus scholars need to be careful in using data on (F/T), since the international aspect of both sales and assets is exaggerated for Europe. In contrast, the regional variable is stable across the three regions of the triad. The distortionary effect of Europe does not appear in the average of (R/TS) of 75.7% and (R/TA) of 76.7%. It can be concluded that the (R/T) variable is more stable and, perhaps, more reliable than the traditional (F/T) variable.

Table 2. Foreign and intraregional sales and assets of large firms by regional origin, 2001–05

 Both variables are preferable to the “scope,” measure, which simply counts the number of foreign countries in which an MNE has subsidiaries. This gives only a vague indication of geographic sales (or asset) dispersion, and it is probably very misleading as it misses the magnitude of sales (or assets) across countries and triad regions. For example, for a UK firm to have a subsidiary in the United States is much more significant than for it to have 12 subsidiaries in the new member states of the European Union. Yet the scope measure would count the UK firm as 12 times more internationalized in Europe than in North America.

 Conclusion

It has been shown here that large firms, including the vast majority of the world’s multinational enterprises (MNEs), operate regionally rather than globally. The 500 largest firms average about 75% of their sales in their home region of the triad. They also have most of their assets in their home region. It is reasonable to assume that smaller firms are even less global and more local in their operations. Indeed, small firms are often associated with large MNEs in localized clusters and act as key suppliers and distributers in partnership with the MNEs. In other words, the world’s largest MNEs act as strategic leaders (flagships) in determining the regional nature of business around the world.

For financial officers, the key implication of the evidence that large firms perform regionally is that new metrics are required to evaluate firm performance. It is no longer appropriate to consider the aggregate ratio of foreign to total sales since interregional sales are more risky than intraregional sales. Rather, it is necessary to use the ratio of regional to total sales. Data have been presented in this article for both types of metrics. It is apparent that the regional sales metric provides important new information to financial officers. New academic work is being undertaken to assess financial performance of large firms using the regional metric rather than the aggregate metric for multinationality. Initial results demonstrate that the financial performance of a firm is better explained by the regional metric than by the old multinationality metric. In the future, business practice and performance metrics for MNEs must be better aligned to the new academic research which has demonstrated the lack of globalization and the regional nature of business activity.

 Case Study

The relationship between multinationality (M) and performance (P) is a traditional topic in the areas of international business and the financing of multinational enterprises (MNEs). In this literature, P, as a dependent variable, is broadly determined by the degree of multinationality, M, where M is usually proxied by the ratio of foreign to total sales or assets, i.e., (F/T). There is either a linear, quadratic, or cubic (S-curve) fit, allowing for controls such as size of the firm, industry grouping, and organizational learning effect over time, etc. (see Rugman (2007)). Recently, this M and P literature has included regional aspects of (F/T) and performance—for example, performance now includes return on foreign assets (ROFA).

There are now better and more detailed data on the geographic dispersion of activities.

The new accounting standards affecting most of the world’s MNEs now make it possible to adopt both a new dependent variable (for performance) and a new independent variable (for multinationality):

1. Performance can now capture the return on foreign assets (ROFA), not just the return on total assets (ROTA).
2. Multinationality is now available on a regional basis, i.e., the ratio of regional (R) to total (T) sales (R/T). This offers better information on the strategic performance of an MNE, in comparison to the traditional metric of the return of foreign-to total sales or assets (F/T).

Further, it is possible to calculate the performance of MNEs using Tobin’s q as a performance measure. While this is restricted to examining the performance of the consolidated MNE, Tobin’s q permits us to modify the accounting data reported by the firms with a stock market capitalization measure. The Tobin’s q captures both the stock market valuation of the firm along with key elements of accounting-based rates of return. In a recent paper Tobin’s q has been explained both by traditional (F/T) measures of multinationality and by the regional variable (R/T). These results are reported in Rugman (2007).

 Making It Happen

Finance professionals need to keep up to date about academic research on the financial performance of multinational enterprises (MNEs). These firms disclose accounting information in their annual reports. Traditionally they disclose their degree of multinationality, usually the ratio of foreign (F) to total (T) operations. Thus it is relatively easy to calculate the F/T for sales and/or assets. The average F/T ratio is approximately 35% for sales and slightly less for assets. Large firms also disclose aspects of their financial performance, including return on assets (ROA). Academic studies traditionally examine the impact of F/T on ROA.

Recently, both variables have been modified. First, we can now assemble data on the ratio of regional (R) to total (T) operations. Most of the world’s largest 500 firms have R/T ratios of over 70% for both sales and assets. Second, many large firms now report the ROFA. This allows us to calculate the performance of foreign subsidiaries. This is a finer-grained performance measure than the traditional ROA. These data showing the impact of ROFA on R/T have been reported in Rugman (2007) and by Rugman, Yip, and Jayaratne (2007).

 Source: qfinance                                                                      Author: Alan Rugman

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